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Thursday, October 23, 2008

The day Apple released its iPhone revenue bomb

Some Apple watchers have complained almost since the launch of the iPhone that Wall Street doesn't understand the device's value to the company. Analysts consistently underestimate Apple's revenue, these investors insist, because they fail to fully account for iPhone sales.

The problem has been festering for so long — and the gap has grown so large between Apple's actual earnings and the Street's grasp of those earnings — that Apple finally let the cat out of the bag Tuesday during its quarterly earnings call.

Measured by so-called generally accepted accounting principles (GAAP), the company earned $1.26 a share in 2008 Q4 on revenue of $7.9 billion. This is the form in which Apple (AAPL) has always reported its income.

But on Tuesday, for the first time, the company went one step further. CFO Peter Oppenheimer told analysts that when measured by actual revenue — counting the full value of every iPhone and Apple TV sold in the quarter — the company earned a good deal more: $2.69 per share on sales of $11.68 billion (see transcript here).

The consensus among analysts before the earnings call was that Apple's revenue for the quarter would be about $8.05 billion. Some traders looked at $7.9 billion and thought Apple had fallen short of the Street's target by $150 million. The smart ones looked at $11.682 billion and realized they'd underestimated Apple's earnings by nearly $3.8 billion. They're probably the reason Apple's share price jumped 12% in after hours trading.

How could the analysts have been so wrong?

In the analysts' defense, the accounting methods Apple uses aren't easy to follow — even though Oppenheimer has spelled them out at almost every earnings call.

For reasons that have to do with being able to provide free upgrades over the life of the phone, Apple doesn't book the full value of, say, a $199 iPhone the day it's sold. Rather, its accountants spread that income out over 24 months, booking $8.29 in the first month, $8.29 the second month, and so on until the revenue from that iPhone has been fully accounted for. (Actually, the value of that iPhone is probably closer to $500, once AT&T has paid its share, but you get the idea.)

Given that Apple's iPhone sales have been growing exponentially over the past 15 months and that each month's iPhone revenue includes not just a share of the sales from that month, but a share of iPhone sales from each of the months that preceded it, you begin to see the dimensions of what one might call Apple's iPhone revenue bomb.

"This is a pretty big deal," Steve Jobs told analysts and journalists on Tuesday, as he made his first appearance at an Apple earnings call in 8 years to try to explain the iPhone's so-called subscription accounting system.

"As long as our iPhone business was small relative to our Mac and music businesses, this didn’t really matter much. But this past quarter, as you heard, our iPhone business has grown to about $4.6 billion, or 39% of Apple's total business, clearly too big for Apple management or investors to ignore."

Oppenheimer and Jobs promised to provide adjusted revenue numbers — so-called non-GAAP revenue — every quarter going forward. But they didn't provide any non-GAAP numbers from quarters past, making it difficult to gauge how fast Apple is actually growing.

That's where Andy Zaky comes in. An amateur Apple watcher — and one of the blogger-analysts who humiliated the professionals in a Q4 earnings estimate smackdown earlier this week (see here) — Zaky stayed up all night Wednesday trying to reconstruct Apple's actual earnings in quarters for which it didn't provide non-GAAP data.

His results, published early Thursday on his blog Bullish Cross, and republished by AppleInsider and Seeking Alpha, show that Apple's revenue actually grew 75% year-to-year last quarter, not the 27% that the company reported, while its real net income grew nearly 125%. The pros could learn a lot by studying his findings.

Zaky's results are summarized in the chart below. To see how he arrived at his numbers, click here.

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